PREMIER CAPITAL MANAGEMENT v. COHEN

The opinion of the court was delivered by: JOAN GOTTSCHALL, District Judge

MEMORANDUM OPINION AND ORDER

Plaintiffs Premier Capital Management, LLC ("Premier Capital"),
TMB, LLC, and Xen Investors, LLC have sued defendants Xentex
Technologies ("Xentex"), Xentex's individual officers and
directors (Larry Cohen, Brian Flanagan, Wan Hee Kim and Michael
Turcotte), a Xentex shareholder (Ron Falese), Northview Bank and
Trust, and the bank's president Blair Robinson, claiming that
defendants violated federal securities laws, as well as several
state statutes and common law prohibitions, when they
fraudulently induced plaintiffs to invest in Xentex.*fn1
Among other claims in their prodigious 39-count complaint,
plaintiffs have brought several state law claims against Xentex's
officers and directors for (1) violations of the Virginia
Securities Act ("VSA"), Va. Code Ann. § 13.1-522, (2) common law
fraud, (3) br each of fiduciary duty, (4) negligent
misrepresentation (against defendant Turcotte), and (5)
accounting malpractice (against Turcotte). Before the court are
two motions to dismiss: the motion of defendants Cohen, Kim,
Turcotte and Falese (the "Xentex defendants") to dismiss
plaintiffs' state law claims, and defendant Flanagan's separate
motion to dismiss plaintiffs' state law claims.*fn2 For the
reasons stated below, both motions to dismiss are granted in part and denied in part.

BACKGROUND

According to the complaint, plaintiffs made two investments in
Xentex, the first through a stock purchase, the second in the
form of a promissory note. Xentex, through its CEO Jeff Batio and
its Vice Chairman and Executive Vice President Douglas Tucker,
first presented plaintiffs with an opportunity to invest at a
meeting on November 1, 2000. At that time, Xentex was in the
process of developing and launching a flip-pad computer known as
the Voyager. During that meeting, plaintiffs received an
Information Statement dated November 1, 2000 (the "Information
Statement"), which contained numerous representations relating to
Xentex, the Voyager computer, Xentex's plans for launching the
Voyager into the market, and the ability of Xentex's supplier,
Korean Data Systems ("KDS"), to finance, manufacture and service
necessary hardware. In reliance on the representations made in
the Information Statement, as well as certain oral
representations made by Batio and Tucker at the November 1st
meeting, plaintiffs invested more than $3.3 million in Xentex
stock. Subsequently, on June 4, 2001, after certain additional
representations by various members of Xentex's Board of
Directors, plaintiffs loaned Xentex $650,000 in return for a
promissory note. Plaintiffs now claim that the representations
made in the Information Statement, the oral representations made
at the November 1st meeting, and various other representations
made in connection with the execution of the promissory note were
false, and that, as a result, defendants have violated federal
and state securities laws and breached various common law duties.
Plaintiffs claim that defendants hid Xentex's deteriorating
financial condition from plaintiffs, thereby obscuring the true
value of plaintiffs' investment.

ANALYSIS

In evaluating a motion to dismiss, the court generally accepts
all of plaintiffs' well-pled allegations as true and draws all
reasonable inferences in plaintiffs' favor, Stachon v. United
Consumers Club, Inc., 229 F.3d 673, 675 (7th Cir. 2000).
Ordinarily, a plaintiff need only plead facts sufficient to place defendants on notice of the nature of
the claims against them and the court will not grant the motion
to dismiss unless it is "beyond doubt that the plaintiff can
prove no set of facts in support of his claim which entitles him
to relief." Conley v. Gibson, 355 U.S. 41, 45-46 (1957);
Fed.R.Civ.P. 8(a).

However, when pleading claims of fraud, plaintiffs must do more
than merely place defendants on notice of their claims. Under
Rule 9(b), a plaintiff must plead "the circumstances constituting
fraud . . . with particularity." In re HealthCare Compare Corp.
Secs. Litig., 75 F.3d 276, 281 (7th Cir. 1996). Specifically,
the complaint must allege "the identity of the person making the
misrepresentation, the time, place, and content of the
misrepresentation, and the method by which the misrepresentation
was communicated to the plaintiff." Sears v. Likens,
912 F.2d 889, 893 (7th Cir. 1990). In other words, a plaintiff must allege
"the who, what, when, where and how" of the fraud.*fn3
DiLeo v. Ernst & Young, 901 F.2d 624, 627 (7th Cir. 1990).

Before turning to the substance of defendants' motions to
dismiss, the court must determine the appropriate pleading
standard by which to measure plaintiffs' claims. As they must,
plaintiffs agree that their common law fraud claims are subject
to Rule 9(b)'s particularity requirements. However, plaintiffs
argue that their remaining state law claims are subject to the
less stringent notice pleading standard of Fed.R.Civ.P. 8(a)
because fraud is not an element of those claims. Plaintiffs'
argument ignores the fact that their VSA claims and breach of
fiduciary duty claims are each premised on the same factual
allegations  that defendants fraudulently induced plaintiffs to
invest in Xentex by knowingly making false representations
regarding Xentex's financial condition, current performance and business prospects. Although plaintiffs couch
their VSA and breach of fiduciary duty claims under different
legal theories, allegations of fraud lie at the core of each
claim and, therefore, those claims are subject to Rule 9(b).
Robison v. Caster, 356 F.2d 924, 925 (7th Cir. 1966)
(holding that if a breach of fiduciary duty claim is based on
allegations of a "scheme to defraud," the claim must be pled with
particularity); Stephenson v. Hartford Life and Annuity Ins.
Co., 02-C-3917, 2003 WL 22232968, *5-6 (N.D. Ill. Sept. 26,
2003) (subjecting plaintiffs' claims to Rule 9(b) standard
because, although pled under different legal theories, each claim
arose from the same allegations of fraud). With that standard in
mind, the court will separately evaluate plaintiffs' claims.

I. Plaintiffs' Claims Under The Virginia Securities Act

As discussed above, plaintiffs' claims under the Virginia
Securities Act must be pled with particularity pursuant to
Fed.R.Civ.P. 9(b) as they are based on allegations of fraud.
Plaintiffs' response briefs state their VSA claims quite clearly:
plaintiffs argue that (1) Xentex made several specific
misrepresentations in the sale of securities in violation of VSA
§ 13.1-522(A) and (2) Xentex's individual board members are
liable for Xentex's misrepresentations under Section 13.1-522(C).
However, plaintiffs' complaint is not so plain. Plaintiffs argue
in their brief that their VSA claims against the individual
directors spring directly from their VSA claims against Xentex.
However, their complaint does not provide such a convenient
cross-reference and the specific misrepresentations at the heart
of each VSA claim are often unclear. For example, the VSA claims
against Turcotte purport to hold Turcotte jointly and severally
liable "for the conduct alleged in this Complaint" without
specifying the "conduct" at issue or referring to any "primary
violation" by Xentex. Rather, defendants and the court are left
to comb through the remaining 116 pages of the complaint to
determine the potential universe of misrepresentations for which
Turcotte is allegedly liable under the VSA.

Moreover, plaintiffs' allegations regarding their theory of
liability are often ambiguous. In their brief, plaintiffs clearly
state that, as "control persons," Xentex's directors are liable
for misrepresentations that Xentex made to plaintiffs in the course
of selling shares of Xentex. However, plaintiffs' VSA counts
often focus on allegations of wrongdoing by the individual
defendant  including alleged misrepresentations that appear
unrelated to plaintiffs' November, 2000 purchase of securities.
Plaintiffs' VSA counts rarely mention any misconduct by the
alleged "primary violator," Xentex. For example, plaintiffs' VSA
counts against Turcotte (Counts XI and XII) appear to be based on
the "representations of Defendant" and list several specific
misrepresentations and GAAP errors made by Turcotte. Counts XI
and XII make no mention of any VSA violations by Xentex and do
not refer to specific misrepresentations made by Xentex. At the
end of Counts XI and XII the question remains: do plaintiffs seek
to hold Turcotte directly liable under the VSA only for his own
misrepresentations or do plaintiffs seek to hold him liable as a
"control person" for Xentex's misrepresentations (which
presumably include misrepresentations made by Xentex's individual
directors)?

Plaintiffs must plead the "who, what, when, where and how" of
the fraud at the heart of each VSA claim. In other words, each
defendant is entitled to know (1) the specific representations
that form the basis of the claims against them, and (2)
plaintiffs' theory for holding that defendant liable for those
misrepresentations. As currently pled, plaintiffs' complaint
falls short of that standard. Plaintiffs must either enumerate
the specific misrepresentations that underlie each count or
provide convenient cross-references that allow each defendant to
locate those alleged misrepresentations. Moreover, the basis of
each defendants' liability, whether as a "primary violator" or
"control person" must be made clear. Based on the relative
clarity of plaintiffs' briefs, the court believes that plaintiffs
are fully capable of remedying the deficiencies described herein.
Plaintiffs' claims under the Virginia Securities Act (Counts XI,
XII, XX, XXI, XXVII, XXVIII, XXXI, XXXII, XXXIII, and XXXIV) are,
therefore, dismissed without prejudice. Plaintiffs may amend
their VSA counts in accordance with this opinion.*fn4

II. Plaintiffs' Common Law Fraud Claims

In contrast to plaintiffs' VSA claims, plaintiffs' common law
fraud claims meet the particularity standard of Fed.R.Civ.P.
9(b):

For example, in Count XXIII against Flanagan, plaintiffs
specifically identify (1) the person making the misrepresentation
(Flanagan individually and as co-author of the Information
Statement), (2) the time, place and content of the alleged
material misrepresentations of fact (five misrepresentations
appearing in the Information Statement created, in part, by
Flanagan, four misrepresentations made during a phone
conversation with plaintiffs' principals and four material
omissions of fact that allegedly should have been disclosed to
plaintiffs during that phone conversation), and (3) the method by
which the misrepresentations were communicated to plaintiffs (in
the Information Statement and by phone conversation). Count XIII
against Turcotte and Count XXX against Kim are equally specific
in identifying the misrepresentations underlying plaintiffs'
claims and plaintiffs' basis for holding defendants liable for
those misrepresentations.

Defendants argue that plaintiffs' claims, nevertheless, must be
dismissed because cautionary language contained in the
Information Statement precludes a finding that the Statement
contained material misrepresentations of fact. See Harden v.
Raffensperger, Hughes & Co., Inc., 65 F.3d 1392, 1404 (7th Cir.
1995) ("[C]autionary language, if sufficient, renders the alleged
omissions or misrepresentations immaterial as a matter of law").
The so-called "bespeaks caution" doctrine precludes liability for
predictions or opinions if the speaker includes sufficient
cautionary language tailored to the risk involved. See id.
However, the "bespeaks caution" doctrine does not, as a matter of
law, insulate misrepresentations of "hard facts" from liability.
See Harden, 65 F.3d at 1406. Plaintiffs allege, inter alia, that Xentex's Information
Statement(1) misstated Xentex's then-current assets, (2) falsely
indicated that Xentex had made necessary preparations to launch
the Voyager computer, and (3) falsely stated that KDS has
supplied $40 million in product financing and had agreed to open
a service depot in Silicon Valley and pay for remaining tooling
and product development costs.*fn5 Those are not "soft"
predictions but, rather, alleged misstatements of then-existing
fact. The "bespeaks caution" doctrine does not as a matter of law
negate the materiality of those statements. Id. at 1406; Wafra
Leasing Corp. 1999-A-1 v. Prime Capital Corp.,
192 F.Supp.2d 852, 870 (N.D.Ill. 2002).*fn6

For his part, defendant Flanagan argues that "this court
already has subjected the fraud allegations of the Complaint to
the Rule 9(b) analysis" and should dismiss plaintiffs' state law
claims for the same reasons it dismissed several of plaintiffs'
federal claims. However, the court has not evaluated plaintiffs'
claims under the Rule 9(b) standard. In addressing the federal
securities claims against defendants, the court evaluated
plaintiffs' allegations under the more stringent PSLRA standard,
dismissing several of those claims based on plaintiffs' failure
to plead facts (1) detailing the reasons why defendants'
misrepresentations were false, and (2) giving rise to a strong
inference that the defendant acted with the required state of
mind. As discussed above, those two PSLRA requirements are above
and beyond what is called for under Rule 9(b). In their common
law fraud claims, plaintiffs need only plead "the who, what,
when, where and how" of the fraud. Plaintiffs have met that
standard; nothing more is required. Defendants' motions to
dismiss plaintiffs' common law fraud counts (Counts XIII, XXIII, and XXX) are,
therefore, denied.

III. Plaintiffs' Breach of Fiduciary Duty Claims

Plaintiffs claim that Turcotte, Flanagan and Kim breached their
fiduciary duty to plaintiffs by fraudulently inducing plaintiffs'
initial purchase of Xentex stock and their subsequent loan of
additional funds to Xentex. Plaintiffs also have sued Ron Falese
for aiding and abetting an unrelated breach of fiduciary duty by
Xentex's CEO, Jeff Batio. Defendants argue that plaintiffs'
claims must be dismissed for failure to adequately plead the
existence of a fiduciary duty. Under Delaware law, officers and
directors of a corporation owe a fiduciary duty to the
shareholders of that corporation. See Malone v. Brincat,
722 A.2d 5, 14 (Del. 1998). However, that duty does not emerge until
there is an actual director-shareholder relationship. Therefore,
to the extent that plaintiffs' breach of fiduciary duty claims
are based on defendants' conduct prior to plaintiffs' purchase of
Xentex stock, those claims must be dismissed. On the other hand,
plaintiffs have adequately pled the existence of a fiduciary
duty with regard to defendants' conduct after plaintiffs'
initial stock purchase.

Defendants argue that, even if defendants owed plaintiffs a
fiduciary duty, plaintiffs' breach of fiduciary duty claims must
be dismissed because they are based on a derivative harm  i.e.
a harm that all shareholders incurred as a result of an injury
suffered by the corporation. In one instance  plaintiffs' claim
against Falese for aiding and abetting a breach of fiduciary duty
(Count XXXV)  defendants' argument is sound. Plaintiffs allege
that, as Xentex approached insolvency, Falese essentially
conspired with Xentex's CEO Jeff Batio to shield a portion of
Xentex's assets from its creditors, thereby impairing Xentex's
ability to pay its subcontractors and depleting the value of
Xentex's assets. That alleged misconduct does not reflect any
unique injury suffered by plaintiffs but rather an injury
derivative of the harm to Xentex that affected all of Xentex's
shareholders (and now affects all of its creditors). Therefore,
if any claim against Falese exists, that claim belongs to the
corporation  or, in this case to the corporation's trustee  in
the first instance. Malone, 722 A.2d at 14. Plaintiffs' claim
against Falese for aiding Batio's breach of fiduciary duty (Count
XXXV) is, therefore, dismissed.

However, plaintiffs' remaining claims for breach of fiduciary
duty (Counts XVI, XXII, and XXIX) are not pled as derivative
claims. In those claims plaintiffs allege that they suffered a
unique harm; they allege that Turcotte, Flanagan and Kim
knowingly made false misrepresentations directly to plaintiffs to
induce their investment in Xentex. As pled, Counts XVI, XXII and
XXIX do not derive from injuries suffered by Xentex's
shareholders at large. If the facts ultimately do not support a
finding that plaintiffs suffered a unique harm, defendants may
move for summary judgment on that basis. However, dismissal of
plaintiffs' breach of fiduciary duty claim in Counts XVI, XXII
and XXIX is not appropriate at this stage of the proceedings.

Unlike the rest of their claims, plaintiffs' claim for
negligent misrepresentation against defendant Turcotte need only
meet the notice pleading standard of Fed.R.Civ.P. 8(a) since it
is not premised on deliberate fraud. See Guaranty Residential
Lending, Inc. v. International Mortg. Center, Inc.,
305 F.Supp.2d 846, 864 (N.D.Ill. 2004). In other words, plaintiffs
need only plead sufficient facts to place Turcotte on notice of
the nature of the claims against him.

To the extent that plaintiffs wish to state a negligent
misrepresentation claim under Illinois law, plaintiffs have met
the Rule 8(a) standard. Plaintiffs have pled that (1) Turcotte
"was in the business of supplying information for the guidance of
others in their business dealings," (2) Turcotte negligently
prepared financial statements tendered to plaintiffs which
contained inaccurate information regarding Xentex's financial
condition and production capabilities, (3) Turcotte provided
financial information directly to plaintiffs to guide them in
their investment decisions, and (4) plaintiffs were damaged as a
result of those negligent misrepresentations. Plaintiffs'
allegations are sufficient to place Turcotte on notice of the
nature of the claims against him. Nothing more is required under
Rule 8(a). Defendants point out that, to the extent that Virginia law
applies, plaintiffs' claim must be dismissed because Virginia law
does not recognize a cause of action for negligent
misrepresentation. While defendants are technically correct,
their argument has no practical effect: Virginia law recognizes a
virtually identical action for "constructive fraud" which is
established upon proof "that a false representation of a material
fact was made innocently or negligently, and that the injured
party was damaged as a result of his reliance upon the
misrepresentation." Layman v. Friedlander, No. 211047, 2003 WL
22785038, *3 (Va. Cir.Ct. Oct. 3, 2003). The court finds that, to
the extent Virginia law applies at all, Count XIV states a claim
for constructive fraud under Virginia law.*fn7

Plaintiffs have placed Turcotte on notice of the nature of
their claim for accountant malpractice as well. Nevertheless,
plaintiffs' malpractice claim must be dismissed because, unlike
most of plaintiffs' other claims, plaintiffs' malpractice claim
alleges a derivative injury, i.e. an injury that primarily
impacted the corporation and its shareholders as a whole. Count
XV is not based on defendants' deception of plaintiffs but,
rather on Turcotte's mismanagement of Xentex's accounts  e.g.,
Turcotte's failure to pay Xentex's bills in a timely manner and
his failure to stop Xentex's Board of Directors from "loot[ing]
the company." In other words, plaintiffs have alleged that
Turcotte played a role in driving Xentex into insolvency. That is
not the sort of "unique injury" that would allow plaintiffs to
bring a direct claim against Turcotte. To the extent a
malpractice claim against Turcotte exists, plaintiffs may bring
that claim only after complying with the requirements of
Fed.R.Civ.P. 23.1. Plaintiffs' malpractice claim (Count XV) is,
therefore, dismissed. CONCLUSION

For the foregoing reasons, Flanagan's motion to dismiss is
granted in part and denied in part and the Xentex defendants'
motion to dismiss is also granted in part and denied in part: (1)
Plaintiffs' claim for accounting malpractice against Turcotte
(Count XV) is dismissed, (2) plaintiffs' claim for aiding and
abetting breach of fiduciary duty against Falese (Count XXXV) is
also dismissed, and (3) plaintiffs' claims under the Virginia
Securities Act (Counts XI, XII, XX, XXI, XXVII, XXVIII, XXXI,
XXXII, XXXIII, and XXXIV) are dismissed without prejudice.
Plaintiffs may file an amended complaint within 30 days of the
entry of this order to remedy the deficiencies in their VSA
claims as described herein.

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